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Investment objectives and constraints are the cornerstones of any investment policy statement. A financial advisor/portfolio manager needs to formally document these before commencing the portfolio management. Any asset class that is included in the portfolio has to be chosen only after a thorough understanding of the investment objective and constraints. Following are various types of objectives and constraints to be considered and several steps to correctly determine these objectives.
Definition of Investment Objectives
Investment objectives are related to what the client wants to achieve with the portfolio of investments. Objectives define the purpose of setting the portfolio. Generally, the objectives are concerned with return and risk considerations. These two objectives are interdependent as the risk objective defines how high the client can place the return objective.
The investment objectives are mainly of two types:
Risk objectives are the factors that are associated with both the willingness and the ability of the investor to take the risk. When the ability to accept all types of risks and willingness is combined, it is termed as risk tolerance. When the investor is unable and unwilling to take the risk, it indicates risk aversion.
The following steps are undertaken to determine risk objective:
- Specify Measure of Risk: Measurement of risk is the most important issue in portfolio management. Risk either measured in absolute or relative terms. Absolute risk measurement will include a specific level of variance or standard deviation of total return. Relative risk measurement will include a specific tracking risk.
- Investor’s Willingness: Individual investors’ willingness to take risk is different from institutional investors. For individual investors, willingness is determined by psychological or behavioral factors. Spending needs, long-term obligations or wealth targets, financial strength, and liabilities are examples of factors that determine the willingness to take the risk by an investor.
- Investor’s Ability: The ability of an investor to take risk is dependent on financial and practical factors that bound the amount of risk taken by the investor. An investor’s short-term horizon will negatively affect his ability. Similarly, if the investor’s obligation and spending are less than his portfolio, he clearly has more ability.
The following steps are required to determine the return objective of the investor:
- Specify Measure of Return: A measure of return needs to be specified. It can be specified in an absolute term or a relative term. It can also be specified in nominal or real terms. Nominal returns are not adjusted for inflation, whereas real returns are. One may also distinguish pre-tax returns from post-tax returns.
- Desired Return: A return desired by the investor needs to be determined. The desired return indicates how much return is expected by the investor. E.g. higher or lower than average returns.
- Required Return: A return required by the investor also needs to be determined. A required return indicates the return which needs to be achieved at the minimum for the investor.
- Specific Return Objectives: The investor’s specific return objectives also need to be determined so that they are consistent with his risk objectives. An investor having a high return objective needs to have a portfolio with a high level of expected risk.
Definition of Investment Constraints
Investment constraints are the factors that restrict or limit the investment options available to an investor. The constraints can be either internal or external constraints. Internal constraints are generated by the investor himself while external constraints are generated by an outside entity, like a governmental agency.
Types of Investment Constraints:
The following are the types of investment constraints:
Such constraints are associated with cash outflows expected and required at a specific time in future and are generally in excess of income available. Moreover, prudent investors will want to keep aside some money for unexpected cash requirements. The financial advisor needs to keep liquidity constraints in mind while considering an asset’s ability to be converted into cash without impacting the portfolio value significantly.
These constraints are related to the time periods over which returns are expected from portfolio to meet specific needs in future. An investor may have to pay for college education for children or needs the money after his retirement. Such constraints are important to determine the proportion of investments in long-term and short-term asset classes.
These constraints depend on when, how and if returns of different types are taxed. For an individual investor, realized gains and income generated by his portfolio are taxable. The tax environment needs to be kept in mind while drafting the policy statement. Often, capital gains and investment income are subjected to differential tax treatments.
Legal and Regulatory
Such constraints are mostly externally generated and may affect only institutional investors. These constraints usually specify which asset classes are not permitted for investments or dictate any limitations on asset allocations to certain investment classes. A trust portfolio for individual investors may have to follow substantial regulatory and legal constraints.
Such constraints are mostly internally generated and signify investor’s special concerns. Some individuals and philanthropic organizations may not invest in companies selling alcohol, tobacco or even defense products. Such concerns and any special circumstance restricting the investor’s investments should be well considered while formulating investment policy statement.
A financial advisor/portfolio managers design and manages the portfolio for an investor after formally documenting the investment policy statement. The job starts from the moment the investor articulates his objectives and constraints. It is for the benefit of both the investor and the manager that the objectives and constraints are correctly determined and not just documented for formality. The more diligence is paid while formalizing objective and constraints, the better is portfolio aligned to the needs of the investor.
References:March 19th, 2018